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Corporate Finance - Corporate Finance Section 2

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41. Soma Autos employs debt financing, borrowing at a rate of 10%. The interest cost at this rate equals Rs.65 billion. For 8 million cars, what is the degree of financial leverage (DFL) for Soma given revenue per car is Rs.25,000, variable cost per car is Rs.14,000 and fixed costs equal Rs.15 billion?

  • Option : B
  • Explanation : Operating income for 8 million cars = 8 million (25,000 – 14,000) – 15 billion = 73 billion. DFL = [Q(P - V) - F] / [Q(P - V) - F - C] = (Rs.73 billion) / (Rs.73 billion – Rs.65 billion) = 9.13.
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42. For firms with a high proportion of fixed costs relative to total costs, a small change in sales will cause a:

  • Option : A
  • Explanation : For highly leveraged firms, that is firms with a high proportion of fixed costs relative to total costs, a small change in sales will have a big impact on earnings.
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43. The following data is available for two companies.

 Siptea Brewers
Number of units sold  200,000200,000
Sales price per unit  $150$150
Variable cost per unit  $43$98
Fixed operating cost 500,000150,000
Fixed financing cost  100,00050,000

  • Option : B
  • Explanation : DOL for Siptea: [200,000 ($150 – $43)] / [200,000 ($150 – $43) – 500,000] = 1.024. DOL for Brewers: [200,000 ($150 – $98)] / [200,000 ($150 – $98) – 150,000] = 1.015.
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44. Asparagus Inc. and Supras Inc. have the same assets, revenue and operating income but Asparagus is more highly leveraged relative to Supras. Which of the following statements is least likely correct?

  • Option : B
  • Explanation : A is a true statement because higher leverage implies a greater interest expense and hence a lower net income. C is true because both companies have the same revenue and operating income. With similar assets, Asparagus has more leverage which means equity is lower. Hence ROE is likely to be higher, not lower, relative to Supras.
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45. The following data is available for Ejaz Business:

Number of units sold 1 million
Sales price per unit Rs. 100
Variable cost per unitRs. 20
Fixed operating cost 5 million
Fixed financing cost 1 million

  • Option : B
  • Explanation : DTL = [Q(P - V)] / [Q(P - V) - F - C] = [1 million (Rs.100 – Rs.20)] / [1 million (Rs.100 – Rs.20) – 5 million – 1 million] = 1.08.
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Corporate Finance Section 2